Bonds

Bonds

Pay a specified coupon at regular intervals (usually semi-annually). And pay face value (= par value) at maturity. Last payment is coupon plus face.

Treasury Auctions

• The U.S. Treasury borrows money by auctioning bonds of various maturities at regular intervals.
  

• They solicit bids from primary dealers of the form “I will buy x bonds at face value if the coupon is at least y.”

• Bidders willing to accept low coupons get their bids filled, and the coupon set on all of the bonds is the lowest that will sell the entire issue.

Treasury Direct

• Individuals can buy bonds at auction via Treasury Direct with simpler bids:

  • “I want x number of bonds.”

• These “noncompetitive” bids are filled first.

• You can also buy bonds at Treasury Direct outside of the auction framework.

Treasury Inflation Protected Securities (TIPS)

How Corporates and Municipals are Issued

• Usually hire an investment bank, who assesses demand from pension funds, insurance companies, brokerages, \(\ldots\)

• Investment bank advises on the coupon needed to sell the bonds near par.

• Investment bank will distribute. It may guarantee sale to company or make “best efforts.”

Bond provisions

• Companies and also other issuers typically have many different issues outstanding – issued at different dates with different coupons.

• Bonds may have covenants that, for example,

  • prohibit the issuance of more debt, or
  • require a minimum income-to-interest ratio, etc.

• Bonds may also have options for prepayment, at the company’s discretion or at investors’ discretion.

Subordination

• Subordinated (junior) means not getting paid in bankruptcy unless all more senior bonds are paid.

• Junior/senior depends on bond provisions, not time of issue.

• All bonds are typically subordinated to any bank debt.

Municipal bonds

• Municipal bonds in the U.S. are exempt from federal income tax.
• Municipal bonds are also exempt from state income taxes in the state of issue.
• So, NY investors want to hold NY municipals, California investors want to hold California municipals.
• Municipals are issued by states, cities, counties, school boards, fire districts, …
• Tax increment financing allows limited use of municipal bonds to back private investments: sports stadiums, etc.

Bond trading

• The bond market is largely an institutional market. Trades are large and made through dealers.
• Securities dealers are like car dealers
  • Stand ready to buy or sell
  • Try to sell at a higher price than they buy
• An individual can trade bonds through a broker, even one-stop online through a broker/dealer.
• But it is hard to know if you are getting a good price.
• Usually better to invest through mutual funds or ETFs.

Asset Backed Securities

• Asset backed securities are bonds that are issued by a trust and are to be repaid from income generated by assets held by the trust.
• A major category is mortgage-backed securities, including those issued by FNMA, GNMA, and FHLMC, better known as Fannie Mae , Ginnie Mae, and Freddie Mac.
• There are also securities backed by auto loans, credit card receivables, bank loans to companies, and other bonds.